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How Optimism Bias Changes Long-Term Projections

Weekend reading: IMF Working Paper, Growth: Now and Forever? by Giang Ho and Paolo Mauro. Those who do not follow the global market in general and the BRICs in particular (or other emerging economies), may not see a correlation to the U.S. market. In reviewing the paper, I would focus more on the psychological behavior of investors and the capital markets, rather than the particulars of emerging markets, their fundamentals, or the drivers in these markets, many of which are quite different from any of the G7. The premise is clearly stated in the abstract,

Forecasters often predict continued rapid economic growth into the medium and long term for countries that have recently experienced strong growth. Using long-term forecasts of economic growth from the IMF/World Bank staff Debt Sustainability Analyses for a panel of countries, we show that the baseline forecasts are more optimistic than warranted by past international growth experience. Further, by comparing the IMF’s World Economic Outlook forecasts with actual growth outcomes, we show that optimism bias is greater the longer the forecast horizon.

Just what do the authors mean by optimism bias? It’s frankly, little more than wish fulfillment. In the authors’ opinions, it is adding more weight to recent occurrences, then extrapolating those positive outcomes across the spectrum of events, where “forecasters often predict continued rapid economic growth into the medium and long term for countries that have recently experienced strong growth.” Again, this does not have a direct correlation to recent events in the U.S., as this economy has experienced forward yet modest growth in the last five years. But could this say anything about the continued expansion in the capital markets, which have little relation to economic events as they tend to affect the average person, employment and a service driven economy? In other words, although the markets seem to be pushing forward at dizzying heights, most would say there is nothing to indicate any kind of an eminent correction. Is the same bias at work in our capital markets? You decide. But the paper makes for an interesting case for why, in spite of argumentation for why global growth may in fact be slow in the coming years, forecasters continue to project strong growth, where predicting “economic growth into the medium term and beyond is notoriously difficult.” It would seem there are lessons to be learned here about bias from any perspective and how this bias has a tendency to affect the view of the future.